Two quarters into 2016 and we have already seen a turbulent year, with January and February lows replaced by some rebalancing in March and April, only for volatility to return at the end of the second quarter with Brexit. While Q1 2016 was likely the bottom of the oil commodity downturn, we have again in recent weeks seen WTI prices fall. This is likely a short-term result of Brexit and the value of the dollar, but nonetheless presents further concern for local and national economies. Projected U.S. GDP for 2016 has now been revised down from 2.4% to 1.8%, with the latest revision for Q1 at 1.1%. Consumer spending and consumer credit remain strong points, fueling about two-thirds of GDP. Recent changes in national employment further underscore the volatility of the first half of the year, dropping to only 11,000 new jobs in May and then bouncing back to 287,000 new jobs in June. Brexit will likely have minimal effects on the U.S., and the world as a whole, as the United Kingdom only accounts for about 4% of global GDP. Yet, Brexit could actually catalyze U.S. commercial real estate investors to remain in the U.S. rather than Central London, where many have previously sought opportunities. The economic outlook for Texas as a whole remains uncertain, though Austin continues forward with another strong quarter.
Net absorption was 124,128 sq. ft. in Q2 2016, a demand for office space that is within its historic Q2 performance. However, leasing activity of 1.2 million sq. ft. was significantly less than its historic Q2 performance. Vacancy ticked up a bit to 9.2%, while availability continued its downward move to 13.2%. About 400,000 sq. ft. of deliveries occurred in Q2 2016, leaving 1.9 million sq. ft. under construction. As Austin’s office market continues to move forward with balance supply and demand, tenant and landlords remain in contest.
While the overall economic outlook has again declined for Texas as a whole, Austin continues its push forward in economic expansion with another strong quarter. Brexit has increased volatility in financial markets, but could lead to increased CRE spending in U.S. as investors shift from Central London. The oil and gas downturn is now manifesting throughout much of Texas, but tech and other support industries of Austin remain stable and strong. Job growth in Austin was a strong 1.9% annualized and the Austin Business-Cycle Index continues to show expansion at 7.1%.
Economic data in recent weeks and months are sending mixed messages for second quarter performance, leading many to further debate whether the economic expansion will continue or reverse course and slide downward. The Leading Economic Index (LEI) declined by a slight 0.2% in May—its third drop in six months—but overall this looks to be short lived. The U.S. gross domestic product (GDP) is now projected to be 1.8% for 2016, a modest decrease from 2.4% in 2015. GDP was revised up to 1.1% for Q1 2016, and is expected to come in around 2.4% for Q2. Strong consumer spending, which accounts for about two-thirds of GDP, will continue to fuel economic growth. Consumer credit further strengthened in May, and strong consumption in April and May will likely account for growth in Q2 2016. Consumer confidence increased 7.6 points in June, though some concern remains in the job market. International trade will continue to decline and hamper GDP with the strong dollar (up nearly 20%). Greater import growth in May led to a wider trade deficit, which is likely to increase by 4% in 2016, following 6.2% increase in 2015.
At the center of the mixed messages in economic data are numbers on employment. Job growth in May dropped to only 11,000, but bounced back higher than expected to 287,000 new jobs in June, resulting in a three-month trend of 147,000 new jobs. With the unemployment rate remaining below 5%, the labor market continues to tighten. However, recent growth in jobs has been in industries with high and low wages, leaving middle-class wages to lag.
After a few months of growth and modest stability following lows in January and February, volatility has again returned to the financial and commodity markets, largely as a timely result of Brexit. Since the vote for the U.K. to leave the European Union, global financial markets have settled down. Effects on the U.S. will likely be minimal over the long term, but uncertainty will continue as the UK and EU begin working out negotiations on their future economic relationships. The U.K. will likely dip into a mild recession later in 2016, but this should not have a large effect on world economics, as the U.K. only represents 4% of global GDP. With uncertainty in the U.K., investors in commercial real estate from the U.S. may shift from Central London and simply remain in the U.S. with its strong CRE industry. To wit, the Dodge Momentum Index, a 12-month leading indicator of non-residential construction spending, jumped 11.2 percent in June and overall in Q2.
The ISM non-manufacturing index increased in June to 56.5, indicating that the economy continues to expand at a moderate pace. Moreover, the NFIB Small Business Optimism Index increased in June for the third month in a row. The ISM manufacturing index indicated that in June factories grew at the strongest rate since early 2015, but growth will remain modest in months to come, as shipments, orders and inventories are still declining, though at a slower rate. Given a variety of headwinds, including low May job growth, financial volatility, and reduced manufacturing, the current speculation is for only one remaining interest rate hike by the Federal Reserve Bank, likely after the presidential election.
The housing market is yet another variable producing mixed economic signals. Both the good-time-to-buy and good-time-to-sell indices increased in June, but the Home Purchase Sentiment Index dropped to 83.2. The high value of the dollar has led the National Association of Realtors to point out that home values by international buyers have decreased by 1.3%. This is leading such buyers to seek out lower-priced homes. Sales of new homes decreased by 6% in May.
Austin and Texas Economy
In comparison to Houston and Texas as a whole, Austin’s economy is moving steadily forward. Employment in Texas, despite the energy pullback, grew 0.4% in May compared to U.S. at 0.3%, with 4,400 new jobs following 14,500 new jobs in April. Unemployment in Texas remains at 4.4%, still lower than the national level of 4.7%. To this end, the Texas Leading Index, which uses key economic indicators to forecast future employment growth, did increase across sectors, suggesting some improvements ahead. Texas retail sales previously declined, but increased modestly in June as evidenced by the Texas Retail Outlook Survey.
In contrast, job growth in Austin was 1.9% annualized over the three most recent months. This moderate growth was broad based, with the exception of manufacturing, which, like the U.S. as a whole, has experienced a slowdown. Growth was strongest among information and other services, retail trade, transportation and utilities, and health care services. The Austin Business-Cycle Index continues to show growth and expansion, but at a slightly slower pace of 7.1% in May (but still above the long-term average of 6%) compared to its prior peak at 10.7% in January 2015. Housing remains strong in Austin (though new home construction permits slipped in May) and other cities and regions of Texas, unlike Houston’s housing market, which has weakened substantially.
With strong demand and low supply, the Austin market continues pushing forward with another solid quarter. The second quarter of 2016 posted 124,128 sq. ft. of net absorption, a demand for office space that was within its historic Q2 performance. Leasing activity of 1.2 million sq. ft. in Q2 2016, however, was significantly lower than its typical historic Q2 performance. Availability decreased to just 13.2%, while vacancy has increased from 3.4% to 9.2%. Deliveries and construction were down by 40-60% YoY.
Demand, as measured by net absorption (direct plus sublease space), is the change in occupied stock inventory. Figure 2 shows net absorption since 2000 by year and quarter for combined Class A and B office space. The second quarter of 2016 posted 124,128 sq. ft. of positive net absorption, representing a substantial decrease of -71% QoQ and -84% YoY (Table 1). The historic Q2 average (± 95% confidence interval) for net absorption is 187,872 sq. ft. (± 233,351). We are 95% certain that Q2 net absorption typically falls between -45,478 sq. ft. and 421,226 sq. ft. Thus, despite the QoQ and YoY decreases, net absorption for Q2 was still within its historic Q2 performance.
Leasing activity is another measure for the demand of office space, representing the total amount of space for direct leases, subleases, renewals, and pre-leasing. Figure 3 shows leasing activity since 2000 by year and quarter for combined Class A and B office space. Leasing activity of 1.2 million sq. ft. occurred in Q2 2016, marking decreases of -3% QoQ and -53% YoY (Table 1). The historic Q2 average (± 95% confidence interval) for leasing activity is 1,560,691 sq. ft. (± 312,455). We are 95% certain that Q2 leasing activity typically falls between 1,247,768 sq. ft. and 1,872,679 sq. ft. This indicates that leasing activity is significantly lower than historic Q2 performance. With net absorption lagging behind leasing activity, lower leasing activity in Q2 suggests lower absorption in quarters to come.
Vacancy and Availability
Vacancy and availability measure the supply of office space, and as such are key indicators of shifts in the phase of the office market cycle. Availability better measures total supply because it includes vacant, occupied, and sublease space. Vacancy better measures empty space in the market, whether or not that space is leased or for rent. Overall, availability has been hovering at or or just below 14% since late 2012, while vacancy has steadily declined from 12% to 8.9% (Figure 4). For Class A and B buildings combined, availability was 13.2%, a decrease of -5% QoQ and no change YoY (Table 1). Vacancy was 9.2%, an increase of 3.4% QoQ, but a decrease of -6.1% YoY (Table 1).
Figure 5 plots asking rent for direct and sublease space since 2000 for each of Class A and B buildings. In Q2 2016, both Class A and B spaces showed increasing asking rents, consistent with the continued low supply under high demand. In fact, for Class B listings, the gap between asking rent rates of direct and sublease space has nearly closed.
Construction and Deliveries
Construction of new stock inventory shapes the supply of office space. “RBA Delivered” refers to completed construction, while “RBA Under Construction” refers to space under construction that has not yet been completed. Deliveries in Q2 2016 were 401,026 sq. ft. of Class A and B buildings, an increase of 17% QoQ but a decrease of -60% YoY (Table 1). RBA under construction was 1.9 million sq. ft. in Q2 2016, a decrease of of -7% QoQ and -39% YoY (Table 1). Figure 6 breaks down deliveries and construction on an annual basis by Class A and Class B products.
Figure 7 depicts changes in the inventory of Class A and Class B buildings since 2000, both in terms of RBA and the number of buildings. Stock inventory for Class A and B office space included 76 million sq. ft. for 2,018 buildings, an increase of 1.8% YoY (Table 1).